5 Homebuilder Stocks Fidelity Is Betting On

BOSTON (TheStreet) -- The U.S. homebuilding industry is still trying to crawl out of the biggest slump in a generation, with most analysts' forecasts calling for anemic growth beginning later this year.

Key data on the housing sector show that growth may be even further away still. The Commerce Department said new-home sales plunged 16.9% in February to a seasonally adjusted annual rate of 250,000, the worst rate since 1962.

But a few investors are placing big bets on the industry now, including Fidelity, the second-largest mutual fund company. It holds stakes in each of the industry's five biggest companies that range from 13% to almost 16% of their outstanding shares, two to three times the size of the next largest shareholder.

A slowly recovering economy after a recession and a decade of overbuilding contributed to the worst housing-market conditions in more than two decades. The industry has been hamstrung by high unemployment, low consumer confidence, tough new lending standards and banks' reluctance to lend.

Ratings firm Standard & Poor's says that despite "challenging" market conditions, "we believe there are some signs that homebuilders could realize positive, albeit slow, growth in the second half of 2011."

Katrina Dudley, a housing industry analyst and portfolio manager at Franklin Templeton's family of Mutual Series funds, said in an interview yesterday the number of new homes being built is likely at a cyclical low and, given the nation's continued population growth, it won't remain there for long.

But when the tide will change is still an unknown, she said. A predictor of that will be steady job creation.

Daniel Kelley, who runs the Fidelity Select Construction and Housing Portfolio (FSHOX - Get Report) , said in an interview yesterday that stable prices will lead to a turnaround. Just last week, the National Association of Home Builders/Wells Fargo Housing Market Index edged up to the highest reading since May 2010. The latest data indicate that "more builders view sales conditions as good, than poor -- which hasn't been the case since April 2006," said the NAHB.

To be sure, the National Association of Realtors this week said weak sales and a rise in foreclosures pushed down February home prices to their lowest level in nearly nine years. Sales of existing homes fell 9.6% from January's pace.

And the median price of a new home is now 45% higher than that of an existing home, three times the historical rate in a healthy market. That indicates that home-resale prices are very cheap and the inventory plentiful, which also works against the demand for new homes.

Fidelity's Kelley said national homebuilders, who own a 30% market share in the highly fragmented industry, have whipped themselves into shape in the downturn, shedding inventory, cutting costs and restructuring their balance sheets, such that they're poised for immediate strong profit growth once the industry rebounds.

"It's still a challenging operating environment for homebuilders, but it seems to me that it looks brighter today than at any point in the past four years as the broader economy is starting to gain a little momentum" and consumers are regaining some degree of confidence, helped by the improving job market and stock markets' gains, he said. His fund holds all five stocks reviewed in this article, below.

The SPDR S&P Homebuilders (XHB - Get Report) exchange traded fund, which tracks the S&P Homebuilders Select Industry Index, is up 3.8% this year through March 21, in line with the gain of the S&P 500 Index. The ETF is up 11% over the past 12 months, versus the 14% gain of the index.

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Lennar (LEN - Get Report) is one of the largest and most geographically diverse U.S. homebuilders, with operations in 15 states. It also provides title- and mortgage-related services, is involved in about 50 joint ventures and owns a distressed real estate unit, Rialto Investments.

Lennar's target market is value-oriented, first-time and move-up homebuyers. In 2009, the company sold about 11,500 homes at an average price of $250,000.

Morningstar analyst Michael Gaiden said in a Jan. 11 research note that Lennar is "a best-of-breed homebuilder and one of our top picks in the sector."

And in a March 15 update, Gaiden said Lennar should "reap major economic gains from an eventual rebound in housing" because the company restructured its balance sheet and re-sized the company making it more efficient. "Overhead cuts of more than 50% from the peak further ensure that eventual increases in revenue fall meaningfully to the bottom line."

But S&P analysts have Lennar shares rated "hold," with a 12-month price target of $21. Its shares are currently trading at $19.67.

S&P says Lennar's revenue should rise 10% in fiscal 2011, following a decline of 5% last year. "We see the company benefiting from its larger contract backlog than many of its homebuilder peers" as well as gaining from higher gross margins due to its mix of sales in its newer communities that were bought at lower land acquisition costs.

It also notes that Rialto recently bought a 40% interest in two portfolios of real estate loans in partnership with the Federal Deposit Insurance Corp. (FDIC) for $243 million. They consist of more than 5,500 distressed real estate loans with a market value of $1.2 billion.

Analysts' ratings, per an S&P survey, are: four "holds," nine "buy/holds" and eight "holds." Those same analysts expect Lennar will earn 64 cents per share this year and $1.24 per share in 2012.

Shares of Lennar are up 5.9% this year and 24% over the past 12 months, giving it a market value of $3.6 billion.

Fidelity's funds own a whopping 14.9% of its shares, which is three times that of the next largest institutional investor. The Fidelity Magellan Fund (FMAGX - Get Report) holds a 7.2% stake.

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D.R. Horton (DHI - Get Report) is one of the country's largest homebuilders by volume and operates in 75 markets in 27 states. Its target market is entry-level buyers. Even in the down market of 2010, it sold almost 21,000 homes.

Morningstar analyst Michael Gaiden said in a March 9 research note that "we believe the firm now sits near a trough in sales performance and the company's financial returns hold the potential for major gains in the coming years."

And he notes the company's financial strength. "With net debt/total book capital of roughly 10% and $1.5 billion of cash on hand, D.R. Horton holds a manageable debt load and sizeable liquidity to navigate the potentially volatile industry conditions of the next few years."

Ratings firm Standard & Poor's has a "sell" recommendation on its shares and a price target of $10, which is 19% below its current trading price of $11.90. It says that despite a 20% sales increase last year, it expects sales to decline by 10% this fiscal year "as the housing market remains weak," but it expects it will post 15% growth in fiscal 2012.

Shares of the $4 billion market-cap company are up 1.8% this year, but are down about 2% over the past 12 months.

Fidelity funds hold a 14.6% stake of its shares, more than double that of the next-biggest investor.

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Pulte Group (PHM - Get Report) is one of the nation's largest homebuilders. It targets first-time, move-up and active-adult buyers in about 70 markets in 30 states. Its brand names include Centex, Pulte and Del Webb. In 2009, Pulte sold 21,000 homes at an average price of $285,000.

Standard & Poor's has its shares rated "buy," and gives the company a four-star rating out of a possible five. It has an $8 12-month price target on its shares, a 12% premium to the current price.

Although Pulte's revenue grew 12% in 2010, and it has a contract backlog of $1.05 billion, S&P expects revenue will decline 7% this year because 2010 results were boosted by its August acquisition of rival homebuilder Centex, which boosted its developable land inventory in attractive markets.

Longer term, S&P expects the company will gain market share "providing we see better execution of its post-merger plan."

Pulte has about $1.5 billion in cash on the books that can be used to build or acquire potential developments and it already has one of the industry's largest land inventories.

Analysts give Pulte two "buy" ratings, one "buy/hold," 16 "holds" and one "weak/hold," per an S&P survey. Those same analysts estimate Pulte will earn 20 cents per share and that will grow to 29 cents per share in fiscal 2012.

Shares of Pulte are down 4.3% this year and 35.7% over the past 12 months, giving it a market value of $2.7 billion.

Fidelity owns 13.2% of Pulte's outstanding shares, over three times that of the No. 2.

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Toll Brothers' (TOL - Get Report) niche is high-end homes, a market that has seen less erosion than mid- to low-priced new homes in the downturn. It has operations in 50 markets in 20 states. Its homes' average selling price is typically about $550,000.

As a result of its strong presence in the high-end market where it's gaining market share, Standard & Poor's analysts give it a "buy" recommendation and a four-star rating out of a possible five.

S&P expects revenue will rise 2% this year and 9% in 2012, with improving operating margins of 15% this year and 16% next year.

S&P gives Toll shares a $24 price target, a 12.5% premium to the current price.

For fiscal year 2011, analysts' consensus estimate calls for earnings of 10 cents per share, rising to 43 cents in 2012.

A review of analysts' ratings by S& P results in two "buys," four "buy/holds," 12 "holds," two "weak/holds" and one "sell."

Franklin Templeton's Katrina Dudley, a portfolio manager on its Mutual Series funds, which have stakes in Toll, said the company looks cheap given its 1.16 price-to-book valuation, adjusted for deferred tax assets, coupled with its strong historical performance compared to its peers.

"In terms of when the stock is going to turn, we don't know," she said, "but its valuation is cheap enough that we're willing to wait for that."

Morningstar analyst Michael Gaiden wrote in a March 15 research note that "Toll holds one of the most attractive long-term business opportunities in homebuilding. The firm's well-managed indebtedness, lean operations and disciplined entrepreneurial style stemming from material inside ownership provide high visibility on the realization of this opportunity."

But a week ago, the investment firm Stifel Nicolaus (SF - Get Report) downgraded Toll to "sell" from "hold," citing a rich valuation relative to the sector, among other factors.

Through March 21, Toll's shares are up 10% this year and 3.3% over the past year, giving it a market value of $3.5 billion.

Fidelity holds a 14.9% stake in the company compared to 4.6% for the next largest shareholder.

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KB Home (KBH - Get Report) builds mid- to lower-priced housing, targeting first-time, first move-up and active-adult buyers primarily in the West and Southeast.

Standard & Poor's has a "strong sell" rating on KB Home, based on its estimate of a share-price value of $12 versus its current price of $13.09.

The ratings firm said KB's revenue fell 13% in its fiscal 2010, which ended Nov. 30, and that revenue this year will be flat.

Morningstar analyst Michael Gaiden said in a Feb. 4 research note that the company is well-managed and "the currently depressed housing market holds high potential for a dramatic rebound in the coming years, providing major upside opportunity for KB Home."

Supporting that outlook is KB's strong balance sheet, with a cash balance of almost $1 billion and relatively modest debt of $700 million.

S&P's review of analysts' rating found four "buys," five "buy/holds," 10 "holds" and three "weak/holds." Those same analysts expect, on average, that KB will earn 1 cent per share for fiscal 2011, and that will grow to 81 cents per share in 2012.

KB's shares are down 0.57% this year and 22% over the past year, giving it a market value of $1 billion.

Fidelity owns 13% of the outstanding shares, a little more than double that of the next largest shareholder.